Downfall of a market darling
The downfall of G8 Education illustrates a common mistake made by investors.
Investing isn't supposed to be easy and, to paraphrase Charlie Munger, if you think it's easy you're probably doing it wrong.
It was only a few years ago that many people thought they'd found an easy way to make money: childcare.
Like most narratives and manias, this one began with some truth. Media reports, anecdotal evidence and perhaps even personal experience all told the same tale: childcare spots were in short supply and parental desperation along with generous government subsidies were supporting ever-higher prices for operators.
There was a fortune to be made in childcare and many investors piled into G8 Education (ASX:GEM), a listed aggregator of childcare centres.
G8's business model is simple. It buys unlisted childcare centres at low multiples and rolls them up into an ASX-listed business where they're priced on higher multiples.
'Rollups' like this can work for a while, but they usually come a cropper in the end. They work best when there are economies of scale to exploit, but there aren't many in this industry.
You can't just funnel more children into a centre without incurring higher costs and, apart from head office, there's limited scope to share costs. G8 didn't try to build a single brand to spread marketing costs.
The best hope for growth is continuing to buy new centres to add to the network. For years, that's exactly what G8 has done and it has reported correspondingly growing profits. Yet that growth was illusory because it could only be supported by acquiring assets. The rate of return on those assets started to fall long before many suspected trouble.
A roll-up must keep buying new businesses to maintain growth and, as you grow, the marginal acquisition gets a little worse while competition ensures your purchase price gets a little higher. Both these problems have bedeviled G8 whose share price has fallen from highs over $5 to just $2 today.
There is another major flaw. Childcare operators compete not just with other profit-seeking peers but also with family daycares, community centres and not for profit centres.
Trying to maximize returns against competitors who aren't trying to make any money at all is a tough ask and helps explain why G8's occupancy rates have consistently fallen.
Another explanation, of course, is more supply. When childcare places were limited and price increases common, high profitability did what it always does – it encouraged competition to build new supply. And that supply is still coming.
The company itself suggests new builds will continue to open for another year at least and it will take longer for capacity to fall again.
The downfall of this one-time market darling serves to illustrate a common mistake made by investors – chasing the narrative.
In G8's case it goes something like this: more women are working, which increases demand for childcare; there is a shortage of childcare; government subsidies make consumers less price sensitive; buy childcare businesses.
The narrative is seductive precisely because it has so much logic.
Yet too many investors forget that a business's profit is determined not by its customer or by industry growth but by competition.
How easy is this business to replicate and how high are the barriers to entry? Those are key questions that are often ignored in the zealous pursuit of a theme.
It's a set of questions that ought to be levelled at some of today's market darlings.
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